Alexander Buchberger New Venture Cost of Equity and Risk Models A Theoretical Analysis Dissertation for the acquisition of the degree of a Doctus rerum politicarum (Dr. rer. pol.) at the WHU – Otto Beisheim School of Management August 2013 First Supervisor: Prof. Dr. Dietmar Grichnik Second Supervisor: Prof. Dr. Christian Koziol Proverb “Success is the result of countless failures you've done in order to attain it.” by Mark Aaron Corrales New Venture Cost of Equity and Risk Models − I Acknowledgment Acknowledgment It has been a long journey during the last couple of years. Completing this study is definitely the peak of my academic career. I could not have come this far without the assistance, support and patience of many individuals. Hereby, I want to express my sincere appreciation to them. My deepest gratitude is to my first supervisor, Prof. Dr. Grichnik. He taught me how to question thoughts and ideas. Concurrently, he has always given me great freedom to pursue independent work. In reviewing my writings, he offered profound comments, which helped to improve my work. I also want to thank Prof. Dr. Koziol who agreed to be my second supervisor for this dissertation. Many friends helped me to stay motivated through these exhausting years. Their support and care is highly appreciated and backed me to overcome setbacks. The people I have met while at WHU Otto Beisheim School of Management in Vallendar and at the state library in Munich have become close and dear friends, and counselors, and to all of you I express my greatest thanks. They spent time with me in the library, at coffee breaks and lunchs, so that no boredom came up. I greatly value their friendship. Moreover, I would like to thank my girl- friend, Kathrin. I deeply appreciate her enduring belief in me. Most importantly, none of this would have been possible without the love and patience of my family. My parents, whom this dissertation is dedicated to, have been a constant source of support, concern, funding, and strength all these years. Last but not least, I would like to thank the Förderverein Kurt Fordan für herausragende Begabungen e.V. for its financial support. Munich, 30 th August 2013 Alexander Buchberger New Venture Cost of Equity and Risk Models − II Table of Contents Table of Contents Acknowledgment ....................................................................................................................... II Table of Contents ..................................................................................................................... III List of Figures ....................................................................................................................... VIII List of Tables ......................................................................................................................... VIII List of Abbreviations ................................................................................................................ IX List of Symbols ........................................................................................................................ XI 1 Introduction ..................................................................................................................... 1 1.1 Motivation ................................................................................................................ 1 1.2 Academic Approach and Research Contributions ................................................... 6 1.3 Structure of Analysis .............................................................................................. 10 2 Key Definitions and Research Focus ........................................................................... 13 2.1 Cost of Capital ....................................................................................................... 13 2.2 New Ventures and Entrepreneurial Finance .......................................................... 15 2.3 Equity Financing and Venture Capitalists ............................................................. 17 3 Cost of Equity Models .................................................................................................. 19 3.1 Model Classification .............................................................................................. 19 3.2 Capital Asset Pricing Model .................................................................................. 21 3.3 Factor Models ........................................................................................................ 23 3.3.1 Single and Multi Factor Models ..................................................................... 23 3.3.2 Arbitrage Pricing Theory ................................................................................ 24 3.3.3 Fama French 3 Factor Model ......................................................................... 26 3.4 Emerging Markets and Cost of Equity Models ...................................................... 26 3.4.1 Market Characteristics and Risk Adjustment ................................................. 26 3.4.2 Emerging Market Models ............................................................................... 28 3.5 Behavioral Finance and Cost of Equity Models .................................................... 32 New Venture Cost of Equity and Risk Models − III Table of Contents 4 New Venture Cost of Equity and Risk ........................................................................ 35 4.1 Risk and Return Profile .......................................................................................... 35 4.2 Idiosyncratic Risk .................................................................................................. 38 4.2.1 Relevance for the Venture Capitalist .............................................................. 38 4.2.2 Types of Idiosyncratic Risk ............................................................................ 40 4.3 Applied Cost of Equity Models ............................................................................. 42 4.4 Important Implications for this Study .................................................................... 47 5 New Venture Risk Factors ........................................................................................... 52 5.1 Internal and External Risk Factors ......................................................................... 52 5.2 Investment Criteria as Risk Factors ....................................................................... 54 5.2.1 The Entrepreneur ............................................................................................ 56 5.2.2 The Market ..................................................................................................... 59 5.2.3 The Product and Services ............................................................................... 60 5.2.4 The Financial Aspects .................................................................................... 61 5.3 Reasons for Regional Differences ......................................................................... 62 5.3.1 Institution-based Theory ................................................................................. 63 5.3.2 Institutional Influences on Investment Criteria .............................................. 66 5.4 Empirical Analysis ................................................................................................. 74 5.4.1 Relevance and Research Contribution............................................................ 74 5.4.2 Selection of Studies and Empirical Methodology .......................................... 78 5.4.3 Descriptive Statistics ...................................................................................... 85 5.4.4 Comparison of Regional Results .................................................................... 89 5.4.5 Limitations ...................................................................................................... 91 6 New Venture Risk Assessment and Reduction........................................................... 93 6.1 Relevance for Venture Capitalists ......................................................................... 93 6.2 Financial Risk Theory ............................................................................................ 95 New Venture Cost of Equity and Risk Models − IV Table of Contents 6.2.1 Risk Preference and Perceived Risk ............................................................... 95 6.2.2 Modeling and Measuring Financial Risk ....................................................... 98 6.2.3 Measurement of Downside Risk .................................................................. 101 6.2.4 Aggregation of Risk ..................................................................................... 103 , 6.3 Risk Reduction Strategies ................................................................................... 107 6.3.1 Venture Capital Contracts ............................................................................ 107 6.3.2 Staging and Monitoring ................................................................................ 109 7 Financial Decision Theory .......................................................................................... 113 7.1 General Decision Theory ..................................................................................... 113 7.2 Biases and Heuristics of VCs ..............................................................................